MeenaKrishnamsetty

MattDoiron (Insider Monkey)

Recent times haven't been good to the coal industry. Thermal coal, for use in electric power plants, has seen reduced demand as utilities have increasingly switched to cheap natural gas (thanks to shale gas, U.S. natural gas production has increased dramatically). Metallurgical coal, for use in steel production, is also not doing particularly well as the global economy has weakened and reduced demand for steel; United States Steel Corporation
X, -4.09%
revenues were down 8% in the third quarter compared to the same period in 2011.

Alliance Resource Partners
ARLP, -0.30%
a $2.1 billion market cap coal miner, has been hurt by these industry dynamics. It reported a 5% rise in revenue for the third quarter of 2012 compared to the same period in 2011, but this was driven entirely by an 18% increase in production. Since higher production was accompanied by higher costs, the company reported a 20% decrease in operating income even excluding an impairment charge. The stock has fallen 26% year to date.

Company insiders seem to think that the market has overreacted to Alliance Resource Partners' troubles. On November 30th, company Vice President and Controller Robert Fouch purchased 8,000 shares of the stock at an average price of $56.99 per share. This came about two weeks after Board member Torrence Wilson had bought 1,000 shares at an average price of $52.87. Studies show that on average insider purchases tend to be bullish signs See more about studies on insider trading).

We think that this is partly because insiders should prefer to diversify their wealth away from the company, and so will tend to avoid buying shares unless they are confident in the stock's prospects. When there is consensus insider buying, studies indicate that the stock will (again, on average) perform even better. We'd also note that Wilson had most recently purchased shares in February 2009, at prices of less than $26 per share. See a history of insider purchases at Alliance.

Hedge funds generally aren't very optimistic on coal stocks, but some managers are starting to increase their holdings in other companies in the industry. In November, Dmitry Balyasny's Balyasny Asset Management reported ownership of over 5% of Walter Energy
WLT, -9.84%
with 3.4 million shares in its portfolio. Billionaire George Soros, meanwhile, initiated a position of 4.4 million shares in Peabody Energy Corporation
BTU, -7.87%
during the third quarter of the year. Check out Soros's new stock picks.

Alliance Resource Partners, L.P. currently trades at 15 times trailing earnings. Wall Street analysts expect considerable improvement in 2013, and so the forward P/E multiple is only 8. We've already mentioned Walter and Peabody as two coal stocks, and would compare Alliance to Arch Coal
ACI, +2.07%
CONSOL Energy
CNX, -0.14%
and Alpha Natural Resources
ANR, +6.67%
Arch Coal and Alpha are expected to be unprofitable both this year and next year. Walter and CONSOL trade at over 20 times forward earnings estimates, suggesting that in those cases the market is being more optimistic than sell-side analysts in terms of how those companies will handle the state of the coal industry.

We'd also note that each of these companies saw their revenues fall at least 10% last quarter versus a year earlier. As such Alliance seems decently priced relative to its industry. Peabody, the Soros pick, carries a forward P/E of 13 which makes Alliance cheaper than that stock on a forward earnings basis as well. Peabody's sales rose in the third quarter from the third, but net income dropped 84%. Some further decreases in earnings are accounted for in analyst expectations.

We've previously argued that Arch Coal, despite its recent struggles, is the best investment in the coal industry due to its strong liquidity and attractive valuation compared to its sales. Given the consensus insider activity at Alliance, as well as decent pricing in terms of forward earnings estimates, that company might now be the best coal stock to buy though it's certainly possible that the entire industry should still be avoided if natural gas prices remain low.

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